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Christopher Towle and Steven Rocco, managers of the
Lord Abbett High Yield
fund, sit next to each other on the open 11th floor of the money manager's Jersey City, N.J., headquarters, close enough to talk bonds all day. They finish each other's sentences when talking about their moves up or down the credit curve, or their financial analysis of one of the fund's 500-plus holdings. "We're credit nerds at the core," Towle says.

That nerdiness has served them well: The $3.1 billion High Yield fund (ticker: LHYAX) has beaten its category for the past one-, three-, five-, and 10-year periods, according to Morningstar. For the past three years, the fund has returned an average annualized 9.1%, trouncing the high-yield category's 7.5%.

It has been a good time to be a high-yield investor: Ultralow interest rates have sent investors searching for yield, while default rates among high-yield corporate borrowers have stayed at historic lows. But potential risks lurk in the Federal Reserve's monetary policy, and in the disappearance of covenants and other structural changes that favor issuers over bondholders.

This year Towle (left) and Rocco are moving back up the credit curve in the belief rates will go lower. So far, so good.
Peter Murphy for Barron's

Last year, with high-yield defaults minimal and investors focused on the Fed's tapering, Towle and Rocco moved down the credit curve, buying bonds rated B and CCC, instead of BB. That move buoyed returns without a lot of added risk. This year, they've started to move back up, adding to those BB holdings, which accounted for 36% of assets at the end of February.

"Being down in credit quality has helped this portfolio. That was very much so last year, and the year before that," Rocco says. "This year, it's been a little bit different. We've shifted out of the CCCs to BBs, to take advantage of opportunities there based on our view that rates would move a little lower. So far, that's helped us."

That ability to respond—and the fund's flexibility to own more than just junk bonds—has helped the portfolio over time. At the end of February, the fund had 83% of assets in high yield, with the rest a mix of bank loans, convertibles, equities, investment-grade bonds, and other instruments. In 2011, seeing opportunities in distressed real estate, for example, the fund snapped up commercial mortgage-backed securities. Today, Rocco says, weaknesses in emerging markets is creating opportunity.

"Lord Abbett does a phenomenal job in fixed income," says Sam Bridgers, principal of Lane Bridgers Schill, a financial-advisory firm in Moorestown, N.J., that has nearly $6 million of clients' money in the High Yield fund. "The yield is there, and the track record is also there."

Towle, 56 years old, has been in the fixed-income business for decades, long enough to have seen credit cycles wax and wane. He was working in the specialty fixed-income area of American International Group, or AIG, when he heard that Robert Dow, the firm's retired managing partner who was then manager of the multisector
Lord Abbett Bond Debenture
fund (LBNDX), was looking for an assistant portfolio manager. "He was fairly well known, and we hit it off right away," recalls Towle, who joined Lord Abbett in 1987. He took over management of the Bond Debenture fund in 1993, and has been a manager of High Yield since 1998.

Lord Abbett High Yield

Total Returns*

1-Yr

3-Yr

5-Yr

LHYAX

8.16%

9.08%

16.70%

Barclays US Aggregate Bond

0.20

4.11

4.98

% of

Top-10 Issuers

Portfolio**

Sprint

1.97%

First Data

1.56

T-Mobile

1.02

Intelsat

0.99

Dish

0.96

Energy Future Intermediate Holding

0.91

Clear Channel

0.78

Alliance Data

0.74

Seven Generations Energy

0.74

CHS/Community Health

0.73

Total

10.40

*All returns are as of 4/10/14; three- and five-year returns are annualized. ** As of 2/28. Sources: Morningstar; Lord Abbett

Rocco, 34, started his career as a consultant at FactSet, the financial-software and data company. He joined Lord Abbett 10 years ago, and is now the firm's lead portfolio manager for its high-yield strategy; he became a manager on the High Yield fund in 2010.

Towle and Rocco's strategy at High Yield relies on digging deep into corporate debt and frequent meetings with companies. Even in today's environment, with high-yield defaults minimal, the most important thing is "just getting the credits right," Rocco says. "In high yield, you're going to win if you own the best credits and avoid the blowups."

TODAY, THEY FIGURE, there are opportunities in bonds whose credit quality and financial strength indicate that they may be upgraded—within the junk universe or, better, to investment grade—over time. "The preponderance of large-company B and BB bonds being upgraded in the past couple of years is a lot bigger than you think," says Towle, pointing to LyondellBasell and Ford. Since the managers do their own credit analysis, they don't care about downgrades, as long as they get paid for the risk. "We care about the technicals. We care about what we rate it," Rocco says.

Consider, for example, the fund's energy holdings. "We have a lot of issues in the Permian Basin, in Midland County, Texas, where the shale revolution is happening," Rocco says. The fund began buying the CCC-plus-rated bonds of Athlon, which have a 7.375% coupon and a maturity of 2021, last April, before the company's August initial public offering. Similarly, the fund holds BB-plus-rated Concho Resources, which has a 5.5% coupon and a 2023 maturity. Both, Rocco argues, have improving credit trajectories, and Concho could get upgraded to investment grade. "The energy names are about asset values," he says. "The technology has worked, and not just in West Texas."

Another upgrade possibility: Fresenius Medical, a provider of kidney dialysis and renal disease care, whose BB-plus-rated bonds have a 5.875% coupon and a maturity of 2022. "Even though the yield is very low on some of these BBs, if you get it right, you're going to earn a pretty attractive return because you'll have your spreads tighten 100 basis points [one percentage point] to reach what BBB would be," Rocco says.

Conversely, they're finding contrarian plays in some of the gold miners, which were pummeled last year. In January, for example, the fund started buying Newcrest Mining, an investment-grade bond that was yielding 6.7% when they bought it. "We think it may get downgraded, but the market is clearly pricing that in, and more," Rocco says, noting that spreads have begun to tighten since their purchase.

While the Federal Reserve is reducing its bond-market purchases, Rocco and Towle don't think rising interest rates are imminent. Instead, they figure, the credit cycle still has more time left. "There's a shortage of yield out there," Towle says. "The $10 billion taper, or a skirmish in some foreign country, can't end that shortage of yield."